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Stocks (and Bonds) for the Long Run

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Equities can disappoint more often than many investors believe. Apart from the four decades up to the 1980s, equities did not systematically outperform bonds.

Article by Joachim Klement, Investment Strategist at Liberum

One of the most-read finance books of all time is Jeremy Siegel’s ‘Stocks for the Long Run’.(1) However, in my view, this is also one of the most misunderstood books of all time because it promotes an unrealistically positive view of equities as this perfect long-term investment that can never fail if you only hold on to them long enough. Don’t get me wrong, I am a big fan of equities and think long-term investors should hold a lot more equities in their portfolio than most do (see here (2) for an interesting view on retirement portfolios), but we are not doing us and our clients a favour if we claim that equities have little to no risk in the long run. This is why I am so grateful to Edward McQuarrie for setting the record straight in a brilliant article (3) that contains so many important insights, that I wrote about it in a three-part series.

In this article, which I recommend all of you read in full, Professor McQuarrie corrects the data that Jeremey Siegel used in his book in the following ways (and I am quoting directly from his paper here):

  1. “Includes securities trading outside of New York, in Boston, Philadelphia, Baltimore, and southern and western cities. The new record covers three to five times more stocks and five to ten times more bonds.
  1. The expanded coverage captures more failures, reducing survivorship bias. Outside of New York, banks failed, turn pikes succumbed to canals, canals lost to railroads, and new railroads fell on hard times and never paid a dividend. States defaulted in the Panic of 1837. Corporate bonds were downgraded or defaulted.
  1. Includes federal, municipal, and corporate bonds, and large numbers of each, as opposed to the one bond used each year by Siegel prior to 1862. The new bond record observes price changes, where Siegel had to infer price change from successive yields.
  1. Calculates capitalization-weighted total return for stocks. The old record was either price-weighted or equal-weighted and lacked information on dividends.”

Based on this expanded data for the US as well as international markets, we can now look at the risks of equity investments in the long run. Is it really true that if one holds on to equities for long enough one is certain to make a profit? The answer is a resounding: It depends.

It depends on what you consider to be the long-term. The chart below shows the worst possible return over 20- and 50-year investment horizons for a series of international equity markets.

Worst returns over 20- and 50-year holding periods for equities
Source: McQuarrie (2023)

I make several observations:

  • If one thinks about the long term as 50 years or more (which is the case for pension funds, endowments, or sovereign wealth funds), then, yes, one is almost certain to make money with stocks. However, note the case of Italy which saw its equity market decline by 0.54% per year between 1961 and 2011 for a 50-year total return of -23.7%.
  • Over investment horizons of 20 years (which is a long-term investment for personal investors) the worst-case scenario has been significant destruction of wealth for every market except the US. The average worst return over 20 years is -3.2% per year, leading to a 20-year total return of -47.8%. Imagine holding on to equities for 20 years and still being left with half the money you started with – and that is before inflation…
  • The US market is the only one without a negative absolute return over any 20-year period, but don’t take this as an endorsement of US stocks. In the past 150 years, the US has not experienced major destruction from wars on its home soil, had no hyperinflation, no civil war, and was one of the very few countries that never defaulted on its government debt. Any of these major crises can kill the equity market for decades and while I don’t expect any of these things to happen in the next couple of decades they are still possible. Similarly, and far more likely than any of these major disasters, economic mismanagement can lead to a permanent decline in a country’s equity market. Remember that Argentina was one of the wealthiest countries in the world in 1900. And look at the Italian stock market and its long-term track record above.
  • Because you never know which country or region is going to be the star performer in the future and which one is going to be a dud, international diversification is key to successful equity investing in the long run. This way, you mitigate the impact of any negative outcome like the onessummarized above.

Yes, equities are a great investment in the long run, but they are not without risk and far from being a sure gain. This is particularly true when one looks at the relative performance of stocks vs. bonds as I will do next Wednesday.

We have seen that even in the worst-case scenario, stocks in most countries had small positive returns after 50 years or so – an investment horizon typically too long for private investors, but entirely normal for institutions. But just because equity investments have a slightly positive return in nominal terms doesn’t mean that they are a great investment. Even over the longest investment horizons, there is a significant likelihood that bonds will outperform stocks.

One of the most common charts in all of finance is the relative performance of stocks vs. bonds in the US in the long run. But as with all long-term historical data, there is a huge risk of survivorship bias. Stocks of companies that went under are often not included in the track record or, the track record of stocks and bonds is based on a very limited number of assets (in the case of Siegel’s ‘Stocks for the Long Run’ bond returns before 1837 were imputed from one bond only).

Edward McQuarrie went to great lengths to reduce this survivorship bias by adding more bonds and stocks from all marketplaces across the US to the data. And with one great chart, he dismantles the myth of stocks outperforming bonds in the long run. The chart below should definitely change your view on the relative performance of stocks vs. bonds in the long run.

Stocks vs. bonds in the long run
Source: McQuarrie (2023)

Outside the post-World-War years from 1941 to 1981 stocks in the US did not outperform bonds by any meaningful margin. Let me repeat that: Apart from the four decades to the 1980s, stocks did not systematically outperform bonds. Sometimes stocks outperformed bonds, sometimes bonds outperformed stocks.

Apart from the four decades up to the 1980s, equities did not systematically outperform bonds.

If we take the entire track record back to 1792 we can see that while stocks are more likely than not to outperform bonds in the long run, even for investment horizons of50 years, the chance of stocks beating bonds is just two in three. Invest for many decades and you still have a one in three chance that bonds will beat your stock portfolio.

Likelihood of stocks outperforming bonds in the US
Source: McQuarrie (2023)

But that is the US case and I have mentioned in the first part that US stock market returns are different from the rest of the world. Luckily, when it comes to the returns of stocks vs. bonds, the US is pretty much middle of the pack when it comes to the worst possible outcome. Most countries show a significant underperformance of stocks vs. bonds in the worst case both over 20 and 50 years.

Worst relative returns over 20- and 50-year holding periods for equities vs. bonds
Source: McQuarrie (2023)

To be clear, I am not trying to convince readers to abandon stocks. As I keep telling everyone, equities are a great long-term investment and in the long run, they are likely to outperform most other asset classes and in particular bonds. The data bears that out with equities beating bonds in two out of three cases.

But I warn against looking at equities as a panacea. Equities can disappoint more often than many investors believe. These overly optimistic expectations about equity returns are what lead to disappointment and make investors turn their backs on stock markets for many years, often at the very moment, stocks start to outperform again (and any investor in UK or emerging market equities will likely nod along right now).

Given these results, one can conclude that even long-term investors should consider bonds in their portfolios as a means of diversification. But for bonds to act as a diversifier to equities, they need to have a low or negative correlation with equities. And in the third and final part of this series, I will look at the long-term trends for the correlation between stocks and bonds.

Read part 3 here.